Shares in Apple Inc. sold off on Wednesday following the company’s June quarter earnings report on Tuesday. AAPL ended the day at US$574.97, down $25.95 (-4.32 percent) on volume of 31.3 million shares trading, more than triple the average volume. I’m going to explain why it happened.
The stock opened at $570, and then traded in a fairly narrow band throughout the day, as shown in the chart below. Investors were punishing the stock for a miss on both gross margins and earnings per share ($9.32 EPS reported vs. consensus of $10.35). In addition, Apple offered much lower than expected guidance for the September quarter, especially for gross margins.
AAPL Chart for July 25th
Source: Yahoo! Finance
Allow me to be blunt: Apple fans who don’t understand the markets are confused by Apple’s selloff, and many of them have worked themselves into self-righteous indignation on Apple’s behalf. After all, a surface examination of Apple’s results doesn’t show a miss, it shows a record June quarter, record iPad sales (17 million units), and record Mac sales for the June quarter (4 million units). In addition, Apple beat its own guidance for the quarter, leading readers to question our coverage of these results as a miss.
That’s not the way the stock market works, however; Apple’s stock price and overall valuation is based not on this quarter’s results or last quarter’s results, but rather on future results. Investors are constantly looking ahead at how they expect a company to perform over the next 3-24 months, depending on the company, and sometimes even further out.
While all that is going on, Wall Street looks to get information from wherever it can. Apple’s notorious secrecy is not limited to its product plans, as the company doesn’t divulge many specifics of its financial performance. Sales numbers aren’t broken down by device, for instance, but are limited to product categories. More recently, Apple CEO Tim Cook suggested that Apple will try to keep secret any companies it buys where it can legally do so.
Analysts and investors, including hedge fund managers, try to learn what they can from Apple’s supply chain, traffic at Apple’s retail stores, earnings reports from any company that has anything to do with Apple’s supply chain, and even from illegally bribing people to sell information on what Apple is ordering.
Thrown into the mix is Apple’s own guidance, which is usually limited to the next quarter’s performance. As noted above, Apple beat its own guidance for the June quarter, but Apple has been sandbagging its guidance for the past 12 years or so. As Sterne Agee analyst Shaw Wu recently put it, Apple offers “vintage conservative guidance.”
When you do that quarter after quarter, year after year, it becomes more of an inside joke than practical guidance, and I’ve personally heard Wall Street professionals laugh about it. Over the years, the game has evolved to predict not whether or not Apple would beat its guidance, but rather by how much Apple will crush its own guidance.
This is a game engaged in by Wall Street analysts and investors, and the members of our own Apple Finance Board have become some of the best prognosticators around.
Accordingly, looking at the June quarter results and saying, “But Apple beat its own guidance” is less than half the picture.
If you’re still thinking, “So what! Apple had a kick ass quarter and that’s all that matters!” read on.
As noted above, Wall Street looks forward at Apple’s future performance when deciding how much the company is worth. By definition, that means that Apple’s stock has already been rewarded or punished ahead of time for what Wall Street has predicted the company will do.
If Wall Street expects Apple to do X, but Apple does 1.1X—in very rough terms, Apple has routinely turned in results closer to 1.3X—the stock will jump because Wall Street hadn’t already valued that .1X performance.
If, on the other hand, Apple turns in results of .96X, Wall Street will punish the stock by taking that .04X valuation off the table. That’s what happened on Tuesday, when the stock closed 4.3 percent lower.
To put this more succinctly, Apple’s stock value is not based on Apple’s guidance, it’s based on Wall Street’s predictions and expectations. Beating its own guidance and turning in a record quarter doesn’t matter that much when Wall Street has already boosted the stock to a price that supports its own predictions.
In a research note to clients on Wednesday, Sterne Agee’s Shaw Wu told his clients, “While light revenue and a potential iPhone unit shortfall were somewhat anticipated ahead of a refresh, EPS and gross margin misses weren’t.”
There’s one more factor, however: Apple’s guidance for the September quarter was also well below what Wall Street had expected, especially for gross margins. Apple guided for gross margins of 38.5 percent, more than 400 basis points lower than many analysts were modeling.
Again, Apple is sandbagging, but the company’s guidance is well below what was expected, and Apple’s stock price had already been priced to include the higher expectations. All that happened today is the process of adjusting to the new expectations.
At the end of the day, Wall Street is very efficient, so efficient that small players (i.e. retail investors) are at a significant disadvantage. Not every analyst understands Apple’s business model and value proposition, but many do. It’s been slow in coming, but Apple’s amazing performance over the last 10-12 years has shown the world that the company is doing something right.
The Street as a whole is a very rational entity, and there is some very, very smart money (i.e. the hedge funds) that are doing everything it can to extract every penny of value out of the market, including Apple.
My personal recommendation is that when you see AAPL movement that doesn’t make sense, rather than assuming that Wall Street doesn’t know what it’s doing, start from the vantage point that maybe someone else knows more than you and work backwards from there. More often than not, there is sound reasoning behind big movements in Apple’s stock, even if it’s macro-economic concerns that aren’t directly related to Apple’s business.
*In the interest of full disclosure, the author holds a tiny, almost insignificant share in AAPL stock that was not an influence in the creation of this article.